The international economy

The outlook for the world economy has strengthened since the August Statement. Global financial markets have continued to recover, confidence
has generally increased and most economies have now seen a return to growth.
After falling sharply in the second half of 2008 and the first quarter of 2009,
global output (with countries weighted by GDP at purchasing power parity exchange
rates) is now expected to grow at an annualised rate of around 4 per cent in
the second half of 2009 (but to contract by around 1 per cent in year-average
terms reflecting the weakness earlier in the year). Global output is projected
to grow by around 3½ per cent in 2010, still somewhat below its trend
pace. Average growth in Australia's major trading partners is expected
to be a little stronger and close to its trend rate (Graph 84).

While output is now expanding again in North America and most countries in Europe,
many of the advanced economies face significant medium-term challenges in dealing
with weak financial sectors and balance sheet problems in both the public and
private sectors. As a consequence, the pace of recovery in the G7 countries
and other advanced economies looks likely to remain subdued. However, growth
is expected to be much stronger in China, India and across other east Asian
economies (excluding Japan), which have higher trend growth rates and have
been less affected by the problems the large advanced economies are experiencing.
While subdued growth in the advanced economies will weigh on exports from the
emerging economies, the latter have significant scope for continued expansion
underpinned by growth in domestic demand.

The projected strong economic performance in Asia is likely to boost Australia's
terms of trade over the forecast horizon. Consistent with the improved global
outlook, spot prices for a range of commodities have increased significantly
since earlier in the year, supported by a structural increase in demand from
China and a recovery in demand from Japan, Korea and Taiwan. As a consequence,
after falling by 17 per cent in late 2008 and the first half of 2009, the terms
of trade are expected to rise over the next couple of years, a stronger outlook
than at the time of the August Statement
(Graph 85).

Domestic activity

As discussed in earlier chapters, the recent flow of data suggests that the domestic
economy is growing, benefiting from the rebound in growth in Asia, the stimulus
delivered by fiscal and monetary policies, and strong growth in the population
and capital stock (for further discussion, see ‘Box F: Growth in the Factors of Production’).
Consumer and business confidence are both high, consumption has been fairly
resilient and, while business investment fell in the first half of the year,
the outlook has improved considerably, driven in part by the resources sector.

The central forecasts are summarised in
Table 13.
In year-average terms, GDP growth is expected to be around 1½ per cent
in 2009/10, 3 per cent in 2010/11 and 3½ per cent in 2011/12. These
forecasts have been prepared using the technical assumption that the cash rate
increases gradually. As noted in the August Statement, this technical
assumption for the cash rate should in no way be viewed as a commitment by
the Board to any particular path for policy. In addition, the exchange rate
is assumed to remain unchanged at current levels, while oil prices are assumed
to move broadly in line with near-term futures pricing.

The economy is expected to record growth of around 2¼ per cent over the year
to the June quarter 2010, a significant upward revision from the time of the
August Statement. This upward revision reflects both the generally stronger-than-expected
data over the past three months and a broader reassessment of the outlook for
the economy. Although consumption growth has moderated relative to the first
half of 2009, following the end of the fiscal payments to households, spending
appears to have been relatively resilient. Business investment is no longer
expected to fall sharply, with spending supported by the improvement in business
conditions, growth in Asia, the positive outlook for the resources sector and
the fiscal stimulus measures. Homebuilding will gradually pick up and some
rebuilding of inventories is likely. Export volumes are also expected to be
relatively firm.

The economy is forecast to grow by around 3¼ per cent over the year to the
June quarter 2011, with a continuing recovery across the various components
of private expenditure offsetting an unwinding of the impact of the fiscal
stimulus measures. GDP growth is expected to pick up further towards the end
of the forecast period. Growth is expected to be particularly strong in the
resources sector as discussed in ‘Box D: Investment
in the Resources Sector’. Growth outside the mining sector is
forecast to be more moderate, reflecting the reallocation of resources within
the economy. The recent appreciation of the exchange rate will be one of the
factors contributing to this reallocation.

Employment growth is expected to be subdued over the next couple of quarters, before
picking up from around mid 2010. With much of the recent downturn in the labour
market occurring through reduced working hours rather than redundancies, hours
worked are initially expected to recover at a faster pace than the number of
employees. That said, the outlook for the labour market has improved since
the August Statement, reflecting the recent better-than-expected employment outcomes
and a pick-up in leading indicators of labour demand such as business surveys
and job advertisements.

Inflation

Underlying inflation has been declining gradually in year-ended terms for the past
year, but at around 3½ per cent over the year to the September quarter,
is still above the Bank's medium-term target. Looking ahead, inflation
is expected to moderate further, reflecting the easing in capacity pressures
over the past year and growth in labour costs. In addition, the recent appreciation
of the exchange rate has unwound the upward pressure on tradables prices from
the depreciation over the second half of 2008. The easing in underlying inflation
is, however, expected to be gradual, given that price pressures in the non-tradables
component have been significant and broad-based in recent years.

Overall, the forecast is for year-ended underlying inflation to decline to around
2¼ per cent by late 2010, before rising modestly to be around the middle
of the target band by mid 2012. The near-term profile for year-ended CPI inflation
is noticeably different from that for underlying inflation, given that CPI
inflation, at 1.3 per cent over the year to the September quarter, is currently
running well below underlying inflation. This reflects large movements in a
few CPI components in earlier quarters, particularly automotive fuel prices
and the ABS estimate of deposit & loan facilities prices. However, CPI
inflation is projected to move broadly in line with underlying inflation from
mid 2010, once these factors have dropped out of the calculation of the annual
rate.

Risks

There are a number of risks to these central forecasts. On the downside, there remains
the possibility that the recent global recovery in activity and financial markets
may falter, with a weakening in the outlook for commodity markets. It is also
possible that the domestic expansion seen to date proves to be mostly a reflection
of the policy stimulus that has occurred, and that private sector demand growth
will be weaker than is currently expected. In this event, GDP growth would
be lower, the labour market weaker and inflation would fall further.

On the upside, with measures of global household and business confidence suggesting
that the extreme pessimism that took hold in late 2008 has eased noticeably,
it is possible that the pace of growth in activity in the advanced economies
in particular will recover more rapidly than expected. Domestic investment
in the resources sector could also prove to be significantly stronger than
in the central forecast, in which it is assumed that not all currently planned
projects proceed. While this would have positive implications for longer-term
potential growth of the economy, the higher level of investment spending and
flow-on to the broader economy could see capacity pressures re-emerging in
the near term and further appreciation of the exchange rate. In this event,
underlying inflation would be expected to decline by less than in the central
forecast.